chAPTER ThiRTEEn • DomEsTic AnD Economic Policy 309
Fiscal Policy
The federal government’s
use of taxation and
spending policies to affect
overall business activity.
Keynesian Economics
A school of economic
thought that tends to
favor active federal
government policymaking
to stabilize economy-wide
fluctuations, usually by
implementing discretionary
fiscal policy.
Budget Deficit
Government expenditures
that exceed receipts.The Business cycle. Economists refer to the regular succession of economic expansions
and contractions as the business cycle. An extremely severe recession is called a depression,
as in the example of the Great Depression. By 1933, actual output was 35 percent below
the nation’s productive capacity. Unemployment reached 25 percent. Compared with this
catastrophe, recessions since 1945 have usually been mild. Nevertheless, the United States
has experienced recessions with some regularity. Recession years since 1960 have included
1970, 1974, 1980, 1982, 1990, 2001, and 2008.
To try to control the ups and downs of the national economy, the government has
several policy options. One is to change the level of taxes or government spending. The
other possibility involves influencing interest rates and the money side of the economy. We
will examine taxing and spending, or fiscal policy, first.Fiscal Policy
Fiscal policy is the domain of Congress. A fiscal policy approach to stabilizing the econ-
omy is often associated with the twentieth-century economist John Maynard Keynes
(1883–1946). This British economist originated the school of thought that today is called
Keynesian economics, which supports the use of government spending and taxing to
help stabilize the economy. (Keynesian is pronounced kayn-zee-un.) Keynes believed that
there was a need for government intervention in the economy, in part because after falling
into a recession or depression, a modern economy may become trapped in an ongoing
state of less-than-full employment.government spending and Borrowing. Keynes developed his fiscal policy
theories during the Great Depression of the 1930s. He believed that the forces
of supply and demand operated too slowly on their own in such a serious reces-
sion. Unemployment meant people had less to spend, and because they could
not buy things, more businesses failed, creating additional unemployment. It
was a vicious cycle. Keynes’s idea was simple: in such circumstances, the gov-
ernment should step in and engineer the spending that is needed to return the
economy to a more normal state.^2
The spending promoted by the government could take either of two forms.
The government could increase its own spending, or it could cut taxes, allow-
ing the taxpayer to undertake the spending instead. To have the effect Keynes
wanted, however, it was essential that the spending be financed by borrowing.
In other words, the government should run a budget deficit—it should spend
more than it receives.Discretionary Fiscal Policy. As mentioned, Keynes originally developed his
fiscal theories as a way of lifting an economy out of a major disaster such as
the Great Depression. Beginning with the presidency of John F. Kennedy (1961–
1963), however, policy makers have attempted to use Keynesian methods to
“fine-tune” the economy. This is discretionary fiscal policy— discretionary mean-
ing left to the judgment, or discretion, of a policymaker.The Timing Problem. Attempts to fine-tune the economy encounter a timing
problem. It takes a while to collect and assimilate economic data. Months or a
year may go by before an economic difficulty can be identified. After an economic
problem is recognized, a solution must be formulated. There will be an actionwww
Helpful Web Sites
Many consider Paul
Krugman to be the dean
of Keynesian economists
today. Follow his New York
Times blog and column by
searching on “Krugman.”John maynard
keynes (1883–1946) argued
in favor of government intervention
to smooth out economic booms and
busts. (Walter Stoneman/Samuel
Bourne/Getty Images)- Robert Skidelsky, Keynes: The Return of the Master (New York: PublicAffairs, 2010).
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